A recent survey found that 23% of Americans in the last year have increased the amount that they’re saving for retirement. Young adults appear to be the biggest savers, which means that they’re getting a head start on planning for their retirement. While it’s never too early to start saving for retirement, one of the issues that my firm has encountered is clients over-planning and creating a nest egg that exceeds their retirement income needs. If you’ve maximized your contributions to your 401(k) and IRA for decades, and have diligently added to a tax-deferred annuity plan, your retirement fund could easily be worth millions of dollars.
Having a multi-million dollar nest egg provides much more flexibility in how you will spend your retirement. But, if you’re concerned about how to deal with large mandatory withdrawals when you reach retirement age, there are some estate planning options that—with the help of a trusted financial advisor—can maximize your retirement savings.
This is the opportune time to start thinking about estate planning and how to pass on your wealth to the next generation. Adding the value of a retirement account to your estate can mean significant taxes; an experienced advisor can help you understand which of your retirement accounts provides the greatest tax risks and benefits. A strategy that I recommend is to leverage your tax-deferred annuity as an estate planning tool, and I’ve outlined some ways to do this below.
Why You Should Not Liquidate an Annuity in a Single Transaction
Before we explore strategies for using your tax-deferred annuity for estate planning, ignore any advice you’ve received to sell your annuity. Annuities, such as 401(k)s and IRAs, are designed to provide retirement income to the policy owner. The key difference between an annuity and other retirement savings plans is that they are essentially guaranteed life insurance contracts, generally structured so that the owner cannot outlive their savings. Liquidating your annuity has several disadvantages:
- Fees may be high: Annuities often have surrender fees which are highest during the accumulation period; getting rid of an annuity during this phase could cost you 8% to 10% of the total value.
- Taxes may be due: The premiums that are paid on a deferred annuity are usually paid with pre-tax dollars, so taxes will be due on any withdrawals you make prior to the payout period. Additionally, gains on annuities are treated as ordinary income, so surrendering your annuity could not only cost you in fees, but in taxes on the gains that your investment may have made as well.
Rather than surrendering an annuity that you’ve paid into, a trusted financial advisor who is knowledgeable in estate planning can help you leverage the value of your annuity to increase the size of your estate.
How to Use Your Excess Retirement Savings for Estate Planning
It is difficult to estimate how much you’ll need in retirement when you’re 30 or 40 years old, and your financial advisor may have advised you to buy annuities to ensure that you don’t outlive your savings. If you have a sizable retirement account that allows you to live comfortably, though, you can consider using your required annuity disbursements to fund an insurance policy that will add significant wealth to your estate. In this manner a series of small, taxable distributions can create a very large, tax free amount to offset estate taxes, or simply enhance your legacy.
There are a few options that allow you to leverage your annuity to purchase a life insurance policy as part of a wealth-building estate plan:
- Donate to charity: By donating all or part of your annual annuity distributions to a charity, this amount becomes tax deductible. The charity can then purchase a life insurance policy using these annual distributions and receive a tax-free, lump sum payout when you pass away. An annual tax-deferred annuity donation of $30,000 could purchase a multi-million dollar life insurance policy with the charity as the beneficiary.
- Exchange a deferred annuity for an immediate income annuity: Converting a tax-deferred annuity into an immediate income annuity with a lifetime income option using a tax-free 1035 exchange will allow you to use annual distributions to cover the premiums on a life insurance policy.
- Gift to family: Take advantage of your annual gift tax exclusion ($15,000 per person or $30,000 per person if you’re married) and use your annual deferred annuity disbursements to gift to an irrevocable life insurance trust or give to family members who can then, in turn, purchase a life insurance policy on you. This estate planning strategy provides a guaranteed, income and estate tax-free payout to your heirs when properly structured.
There are strict rules when it comes to each of the above annuity maximization options, which, if not followed, could lead to penalties. Strategies for annuity conversion and charitable contributions are complex, and they should not be undertaken on your own. Once you’ve considered some of the options available for your well-funded retirement plans, it is time to consult with an expert.
Howard Kaye Insurance has been advising clients on annuities, estate planning, and life insurance for more than 55 years. We have developed strategies specifically for estate planning using annuities and life insurance to maximize wealth transfer. Contact a Howard Kaye advisor at 800-DIE-RICH to discuss strategies for leveraging your tax-deferred annuities as part of your estate plan.
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